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Employment Benefits and Divorce

Who pays the tax?

BY LARRY MAPLES AND MELANIE JAMES EARLES

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EXECUTIVE SUMMARY

FOR MANY COUPLES, THE MONEY
THEY HAVE in employee benefit plans
represents the most valuable asset accumulated
during their marriage. Dividing these funds in the
event of a divorce is a complex process fraught with
serious tax implications CPAs need to be aware of to
counsel divorcing clients.

UNDER IRC SECTION 1041,
TRANSFERS BETWEEN spouses in a divorce
are generally tax-free. But the code is silent on
what happens if the transfer includes unpaid
income, encouraging the IRS to apply a
court-developed assignment of income doctrine to
tax the person making the transfer. For IRA or
qualified plan transfers, a court-issued qualified
domestic relations order (QDRO) can override the
assignment of income doctrine.

THE TIMING OF THE QDRO CAN
HAVE MAJOR TAX implications. A spouse
transferring qualified plan benefits before the
court issues a QDRO may not only disqualify the
plan but can also cause negative tax consequences.

WITH THE POPULARITY OF STOCK
OPTIONS, virtually every state now
considers vested options to be marital property.
Some courts are even going after unvested options.
A client who transfers a nonqualified option to a
former spouse under a divorce decree is taxed at
the time of the transfer.

THE TRANSFER OF AN
INDIVIDUAL’S INTEREST IN AN IRA t o a
former spouse under a divorce decree is not
taxable to the individual. The interest is treated
as the former spouse’s IRA. To qualify for
tax-free treatment, the transfer must be of the
participant’s interest in the IRA and must be made
under an IRC section 71(b)(2) divorce or
separation instrument.

LARRY MAPLES, CPA, DBA, is COBAF
Professor of Accounting at Tennessee Technological
University in Cookeville. His e-mail address is lmaples@tntech.edu
. MELANIE JAMES EARLES, CPA, DBA, is assistant
professor of accounting at Tennessee Technological
University. Her e-mail address is mearles@tntech.edu
.

aby boomers have trillions of dollars
invested in employee benefit plans. For many
couples, these benefits represent the most valuable
asset they have accumulated during their marriage.
Dividing the spoils in a divorce is fraught with
serious tax implications that CPAs should examine
carefully.

This article provides
an in-depth look at the rules CPAs need to
know—including IRC section 1041—so they can counsel
divorcing clients on the tax implications of
retirement plan balances in a property settlement.

RULES OF THE ROAD

Section 1041 provides
tax-free treatment for property transfers between
spouses in a divorce. But what if the transferred
property includes unpaid income? For example,
section 1041 doesn’t address accrued interest on
bonds. The code’s silence has encouraged the IRS
to apply the court-developed assignment of income
doctrine to tax the person transferring the
accrued income. Under this doctrine, income will
be taxed to the owner of the property regardless
of who enjoys the income.

But should this doctrine apply if there
is no underlying asset? For example, in a transfer
of rights to receive part of a monthly retirement
benefit, the property transferred is simply the
benefits to be paid. Does the “no gain or loss rule”
in section 1041 cover this kind of transfer? The IRS
has taken the position that assignment principles
prevail over section 1041 when a taxpayer transfers
the right to receive income, but the issue is
unsettled because the IRS is facing some opposition
in the courts.

Two key factors in some transfers
of employment benefits are whether a court-issued
qualified domestic relations order (QDRO) is in
effect and the timing of the order. For IRA or
qualified plan transfers, a QDRO can override the
assignment of income doctrine. But the IRS will
continue to apply assignment principles to other
types of benefits such as nonqualified plans.

PERSONAL SERVICES INCOME

It is a long-standing
precedent that a taxpayer may not escape the tax
burden on income assigned to another ( Lucas
v. Earl, 2 USTC 496 (USSC, 1930);
Helvering v. Eubank, 40-2 USTC
9788 (USSC, 1940)). It is possible to escape this
rule only when a taxpayer also transfers the
property that is the source of the income. For
example, a shareholder can escape being taxed on
dividends only by transferring the underlying
stock. Since personal services flow from an
individual’s personal capital, a “property”
transfer is not possible. Under what circumstances
would the IRS allow an exception to this general
rule? In Kochansky (96-2 USTC 50,431
(CA-9, 1996) aff’g on this issue TC Memo
1994-160), the taxpayer made two interesting
arguments in an unsuccessful attempt to avoid
being taxed on part of a fee he had assigned to
his former spouse.

At the time of his
divorce, Kochansky, an attorney, was representing
a client who had filed a medical malpractice
lawsuit. The divorce agreement provided that
Kochansky and his wife would split (after
expenses) the contingent fee from this lawsuit.
When the malpractice case was settled, Kochansky
and his former wife each received and paid tax on
one-half of the fee. The IRS contended, however,
that the entire fee was taxable to Kochansky as an
assignment of income.

Kochansky made two
arguments to the Ninth Circuit Court of Appeals.
First, he contended that the courts have held in
several cases that taxpayers may not be taxed on
an assignment where the claim is “uncertain,
doubtful and contingent.” (See Jones ,
62-2 USTC 9629 (CA-5, 1962); Cold Metal
Process Company, 57-2 USTC 9921 (CA-6,
1957); and Dodge , 78-1 USTC 9348 (D. Ct.
Or., 1977)). In two of these cases, however, the
Ninth Circuit saw an underlying asset transfer and
not merely a transfer of the right to receive
income.

In Jones, the taxpayer transferred
a disputed claim to a corporation to which he had
earlier transferred all of his business assets.
The corporation financed the remainder of the
litigation to collect the claim. In Cold
Metal, the taxpayer transferred a disputed
patent the government was attempting to cancel. In
not following these cases, the Ninth Circuit sent
the message that there is a difference between
when the underlying asset is of questionable value
and a Kochansky situation where the only
underlying asset is the taxpayer. Interestingly,
one of the cases the taxpayer cited involved a
transfer of contingent income from personal
services.

In Dodge , a decedent
had entered into an oral agreement 30 years before
his death whereby he promised to devote his time
to managing his brother’s business affairs in
exchange for the brother’s promise to leave half
of his estate to the decedent’s daughter. The
court did not tax the estate on an assignment of
income to the daughter because of the “doubtful
nature of the decedent’s claim.” However, the fact
pattern in Dodge can be considered
unusual.

At any rate, in Kochansky
, the Ninth Circuit clearly rejected any
suggestion that the mere contingency of personal
service income would permit the taxpayer to escape
taxation by assigning it to someone else.

Kochansky’s second argument was that because
the couple lived in Idaho, his former wife had a
community property interest in the contingent fee,
making it her separate property at the time of the
divorce. The appeals court would not consider this
argument since it was not raised at the trial
level, but this point may be relevant in some
circumstances.

QUALIFIED PLANS

A separate property
interest may cause the nonparticipant spouse in a
qualified plan to be taxed on amounts he or she
receives. For example, in Mess (TC Memo
2000-37, following Eatinger , TC Memo
1990-310 and others), the court held that the wife
be taxed on amounts she had received from her
former husband’s military pension. Under
California law, she had a community property
interest in her spouse’s retirement pay. The court
said the result would be the same whether she
received the amounts from the government (as here)
or from her former spouse. A similar result should
hold when other types of income rights exist at
the time of a divorce. For example, the
participant may have irrevocably elected a
qualified joint and survivor annuity.

If
there is no preexisting income right, a qualified
plan distribution will usually be taxed to the
plan participant. In Darby (97 TC 51
(1991)), the Tax Court held that a lump sum
distribution to a nonparticipant spouse, who had
no right to the money until the court assigned it
to her in the divorce, was taxable to the
participant spouse. Despite the fact a lump sum
was involved, section 1041 was not discussed in
the case presumably because the nonparticipant
spouse was not exchanging any preexisting rights
for the lump sum.

But a lump sum payment
where the nonparticipant spouse has preexisting
rights may trigger nonrecognition under section
1041. In Balding (98 TC 368 (1992)), the
court said section 1041 prevailed over assignment
of income principles where the wife relinquished
her community interest in her husband’s military
retirement benefits in exchange for cash. The IRS
argued the wife should be taxed immediately on an
anticipatory assignment of income, but the court
said section 1041 shielded the payment from
current income. It did not answer the question of
whether she would have to report income when her
former husband began to collect his pension. When
that question arises, the IRS will likely respond
that her share of the future payments is an
assignment by the wife to the husband, which will
be taxable to her. The ultimate disposition of
this issue in the courts may depend on whether
they view the situation as a single transaction
under section 1041 or bifurcate it into a
nontaxable lump sum under section 1041 followed by
a taxable assignment of income when the pension
payments begin.

THE ROLE OF QDROs

Under IRC section
401(a)(13)(B), a QDRO will override the assignment
of income doctrine for qualified plans. Thus an
alternate payee who is a spouse or former spouse
will generally be taxed as the “distributee” under
IRC section 402. But CPAs should note that this
shift of tax burden applies only to spouses and
former spouses. The employee-participant will
remain the taxable distributee on amounts paid to
others such as children.

The timing of the
QDRO may have major tax and nontax ramifications.
For example, if an employee dies before the court
enters a QDRO, the spouse loses any right to a
survivor annuity. Or if the employee remarries
before a QDRO is entered, the new spouse’s rights
to a survivor annuity supersede those of the
divorced spouse ( Hopkins v. AT&T
Global Information Solutions Company, 105
F.3rd 153 (CA-4, 1997)). CPAs should closely
examine when benefits start to the nonemployee
spouse under a QDRO. Under ERISA, the alternate
payee may begin receiving benefits when the
employee attains the earliest retirement age under
the plan, making it unnecessary to delay benefits
until the employee’s retirement.

Transferring qualified plan benefits before a
QDRO may not only disqualify the plan but also
cause negative tax consequences. The employee will
be taxed on a premature distri-bution, plus a 10%
penalty. The nonemployee will be treated as having
received a tax-free transfer under section 1041.
However, if the distribution exceeds $2,000,
rolling over the entire amount to an IRA will
trigger a penalty for excess contributions. Trying
to escape this penalty by rolling money into an
ineligible plan such as a tax-sheltered annuity
will cause the entire distribution to be taxable
under section 402(c)(8)9B.

HANDLING NON QUALIFIED PLANS

Nonqualified plans
lack some of the tax incentives qualified plans
offer. For example, the employer may not qualify
for an immediate deduction and distributions are
not subject to special tax breaks. But the plans
are common because they are not subject to
discrimination rules, making them useful in
rewarding key employees.

Nonqualified plan
distributions are taxable to the distributee, but
section 402(b)(2) does not define distributee to
include spouses and former spouses. Thus the IRS
will usually tax the employee under assignment
principles. For example, a professional baseball
player transferred part of his unfunded deferred
compensation plan to his wife in a divorce
settlement. The IRS refused to apply section 1041
as per the Tax Court’s Balding decision.
Instead, it applied assignment principles and
taxed the ballplayer (LTR 9340032). This IRS
attempt to narrow the focus of Balding
will likely result in additional litigation.

STOCK OPTION OPTIONS

CEOs of 180 of the
nation’s largest public companies held an average
of $28.7 million in options on their company’s
stock at the end of 1997, according to the
compensation firm Pearl Meyer & Partners.
Until the 1980s stock options were not even
considered property to be distributed in a
divorce. But now, virtually every state considers
vested options to be marital property. Courts are
also going after unvested options granted during
the marriage but not yet exercisable at the time
of the divorce.

There are two
classifications of options: statutory or qualified
options—those granted under and governed by
specific code sections—and nonstatutory or
nonqualified options—those governed by the more
general code principles of compensation and income
recognition. The employer determines the type when
making the option grant; tax treatment differs for
the two types of options.

There are two
kinds of statutory (qualified) options: incentive
stock options (ISOs) under IRC section 422 and
options granted in employee stock purchase plans
(IRC section 423). Certain rules apply to all
statutory stock options that do not apply to
nonstatutory options. Only the individual to whom
they are granted may exercise statutory options
unless the right passes by will or law at the
grantee’s death. IRC section 424(c) allows
transfers of these types of options pursuant to
divorce only after the options have been
exercised.

If someone disposes of an
option before exercise, the tax treatment depends
on whether the disposition is at arm’s length. If
it is, the transferor recognizes compensation
income equal to the amount realized over the
amount paid to acquire the option. If the
disposition is not at arm’s length, the tax
treatment is the same except the transferor will
also recognize additional income when the
transferee exercises or otherwise disposes of the
option.

When a taxpayer transfers a
nonqualified stock option to a former spouse
pursuant to a divorce decree, under IRC section 83
the transferor is taxed at the time of the
transfer. Generally, transactions between related
parties are not considered to be at arm’s length.
However, in Davis, the U.S. Supreme Court held
that stock transfers between spouses pursuant to
divorce were at arm’s length, causing recognition
of gain to the transferor spouse. Even though
section 1041 nullified Davis on the
recognition of gain requirement, the fact that
transfers pursuant to a divorce are arm’s-length
transactions still stands. Thus, when section 1041
does not apply to a transfer, taxable income can
result.

In FSA 200005006, the IRS found
section 1041 (nonrecognition of gain or loss)
should not apply to stock option transfers
pursuant to a divorce, because the options’ value
is considered compensation, not gain. In this case
the IRS ruled the husband had to recognize
compensation income when he transferred both
incentive and nonqualified stock options to his
ex-wife. Because of the ISO rules (only
transferable upon the optionee’s death), options
that were ISOs in the husband’s hands became
nonqualified in the hands of his ex-wife. She
received a carryover basis equal to the
compensation her husband recognized. Since the
transfer was at arm’s length, there were no
additional tax consequences to the husband when
his ex-wife later exercised the options.

Another factor for CPAs to consider in the
transfer of stock options pursuant to a divorce is
the community property laws in the taxpayers’
state of residence. There are nine community
property states: Arizona, California, Idaho,
Louisiana, Nevada, New Mexico, Texas, Washington
and Wisconsin. In letter rulings 8751029 and
9433010, the IRS ruled that the proposed division
of options under the divorce decree was a
nontaxable event because under the community
property laws, the nonemployee spouse had always
owned half the options. Presumably, the taxpayers
in FSA 200005006 did not live in a community
property state.

Divorce-related stock
option transfers must be valued for income tax
purposes before exercise . This is
especially difficult considering the compensation
the employee spouse receives in exchange for the
options may not be ascertainable. Parties to a
divorce agreement might want to consider
transferring assets other than options or agree to
transfer the aftertax proceeds once an option is
exercised.

IRA ISSUES

IRC section 408(d)(1) requires a taxpayer to
include in gross income an amount paid or
distributed from an IRA. However, under the
section 408(d)(6) exception, the transfer of an
individual’s interest in an IRA to a
former spouse under a divorce decree is not
taxable to the individual. The interest is treated
as the former spouse’s IRA. However, taxpayers
must meet two requirements: There must be a
transfer of the IRA participant’s interest in the
IRA to the spouse or former spouse, and such a
transfer must have been made under an IRC section
71(b)(2) divorce or separation instrument.

Two cases illustrate taxpayer failures to meet
the first requirement. In Bunney (114 TC
259 (April 10, 2000)), the court ordered Michael
Bunney’s IRA divided equally between the parties.
Michael withdrew money from his IRA, deposited it
in a money market account and then transferred
funds to his former wife to buy out her interest
in the family home. The Tax Court agreed with the
IRS that Michael was the sole recipient of the
distributions and held that the entire amount was
includable in his gross income. The transfer did
not meet the exclusion requirements because Bunney
did not transfer his interest in the IRA. Rather,
he cashed it out and gave his former wife the
proceeds.

In a 1995 divorce judgment, the
court ordered Richard Czepiel to pay his ex-wife
$29,000. To satisfy the judgment, Czepiel
liquidated his IRAs (his only assets). In
Czepiel (2001-1 USTC 50,134, (CA-1,
2000) aff’g TC Memo 1999-289), he argued the
divorce judgment was a QDRO because the court had
in effect ordered him to make the withdrawal,
since his only funds were in his IRAs. The court
agreed with the IRS that the divorce judgment was
not a QDRO. If a legitimate QDRO is involved, the
timing of the transfer can be crucial. The Tax
Court would not permit tax-free treatment of a
rollover from an employee’s IRA deposited in the
spouse’s IRA before the court entered a QDRO (
Rodoni, 105 TC 29 (1995)).

An
interest in an IRA must be transferred subject to
the divorce or separation agreement. IRS
Publication 590 describes two methods of
transferring an IRA interest: Change the name on
the account to that of the nonparticipant spouse,
or direct the trustee to transfer the IRA assets
to the trustee of an IRA the nonparticipant spouse
owned. If a client has mistakenly taken a
distribution, he or she has 60 days to roll the
proceeds into another IRA.

AVOIDING SURPRISES

The taxation of
employee benefits in a divorce has been the
subject of much recent litigation. The entry of a
QDRO, the timing of transfers, community property
laws and the harmful tax consequences of
transferring some types of employment benefits are
all factors CPAs should consider when advising
clients involved in a divorce. Given the changing
landscape, CPAs should carefully review all recent
court cases and other developments as they help
clients negotiate divorce settlements to avoid
unpleasant surprises.

The results of the 2016 presidential election are likely to have a big impact on federal tax policy in the coming years. Eddie Adkins, CPA, a partner in the Washington National Tax Office at Grant Thornton, discusses what parts of the ACA might survive the repeal of most of the law.